What is Debt vs Equity Financing? Pros and Cons of Each for Small Business
Debt financing for small business owners is not an uncommon way of funding. Sometimes debt financing is the only choice. When a company’s day-to-day operations or large acquisitions demand finances, it may be necessary to seek outside funding. External financing may be required if internal financial sources, such as the firm owner’s personal funds or cash from family and friends, are unavailable.
Taking on debt to support operations or selling shares of your company to investors are the two primary forms of external financing for business operations. Both sources of funding have benefits and drawbacks, and which one you choose is determined by your business goals.
Because you don’t yet have a track record, debt may be tough to secure in the early phases of a business.
Before you evaluate the benefits and drawbacks of debt financing, which may vary depending on the type of debt you use to run your business, it’s important to first grasp what it is.
Debt Financing Defintion
Debt finance for a small business refers to the practice of borrowing money from a third party to keep the company afloat. According to the loan terms, the business owner is responsible for repaying the principal amount as well as a percentage interest charge. When a loan is taken out, a repayment schedule for the principal and interest is usually created. When you think about debt finance, you would imagine borrowing money from a bank in order to acquire a bank loan. However, depending on the demands of the firm and its ability to repay the loan, there are a variety of additional debt financing options. Each has advantages and disadvantages depending on the riskiness of the business and its stage in the life cycle.
Debt financing can be either short-term (with a maturity of less than a year) or long-term (with a maturity of more than a year) (with a maturity of more than a year). Debt can be secured (backed up by collateral) or unsecured (no collateral) (not backed by collateral). Owners of extremely small, local firms can use accounts payable, also known as trade credit, or even their own credit cards to fund their operations. For example, the Small Business Administration (SBA) is a federal agency that provides business loans. Larger organizations, on the other hand, have a wider range of debt financing options, from bond issuance to venture capital.
Debt vs Equity Financing? Pros and Cons of Each
A business takes on debt or equity financing because it needs money to stay afloat or expand. The practice of borrowing money and using the revenues to keep or expand activities is known as debt financing. The process of selling a share of your company to other investors is known as external equity financing. When an owner provides personal funds to the company, as well as donations from family and friends, this is known as internal equity financing.
A combination of loan and equity finance is used by many businesses. Many businesses are compelled to employ some type of equity financing in the early phases of their existence. As a company has a financial track record that can be documented by financial statements, debt financing becomes a more realistic and likely preferable option.
Debt Financing Pros and Cons
- Doesn’t dilute the owner’s stake in the company.
- The lender has no right to future profits.
- Debt obligations can be predicted and arranged for.
- Interest is deductible on your taxes.
- Debt financing provides a variety of collateral and repayment options.
- Debts must be paid back.
- Depending on your financial situation and credit score, it may be tough to qualify for.
- Some debt structures make it difficult for enterprises to pursue other forms of financing.
- Higher debt-to-equity ratios raise the company’s financial risk.
- It’s possible that owners will be asked to personally guarantee the loan.
- Assets could be seized in case of default
Equity Financing Pros and Cons
- There is no requirement to pay dividends on equity.
- Investors with relevant industry experience and contacts.
- If a business fails, investors’ money does not have to be returned.
- Reduces leverage, which improves the financial health of the company.
- Having to give up a piece of one’s ownership.
- Because investors take more risks with equity, it costs more than debt.
- Getting a loan is easier than attracting investors.
Raising money for your business and finding the right type of financing can be time-consuming and stressful. To keep cash on hand while pursuing options, owners may also want to consider a small business loan in the interim.
Use of Debt Financing
There are various situations where debt financing is better than equity funding:
Debt finance, rather than equity financing, may be a better option for fast-growing businesses. Fast-growing businesses require increasing quantities of capital. Because interest payments made on debt are tax-deductible, debt financing is less expensive than equity financing. In order for debt financing to be successful, the company must be able to generate enough cash flow to cover the debt financing’s interest payments.
Another instance where debt should be used instead of equity is when a company needs short-term funding. Short-term debt financing is used to fund a company’s working capital needs, such as accounts receivable and inventory, and typically expires in less than a year.
Debt financing does not require the firm owner or manager to relinquish any control or ownership interests.
Debt Financing Alternatives
Here are some alternatives to consider when debt financing may not be viable.
- Mezzanine financing is a high-interest, unsecured loan that allows investors to convert debt into equity, especially shares in the company if the company fails on the loan.
- Hybrid financing: A company’s weighted average cost of capital can be reduced by combining loan and equity financing in the right proportions.
- Crowdfunding: Small businesses will occasionally try their hand at fundraising on one of the internet’s crowdfunding platforms.
- Credit card financing: You can use your credit cards to fund your business, but you will have to pay a high-interest rate and adhere to rigorous payback terms. The viability of utilizing credit cards is also influenced by your credit history and the amount of money you require.
- Savings: Internal equity financing is money borrowed from savings and family and friends.